Stocks v property: Get ringside with a fundie and a mortgage broker

Residential property is not an investment income play, despite what many Australians think they know about real estate. So says Chris Bates, a financial planner who ditched the advice gig a while ago and focused his firm, Wealthful, solely on mortgage broking.

“It's purely a capital growth asset,” Bates said during a recent interview as part of Livewire’s Income Series.

“One of the biggest mistakes - and this is what many property spruikers do - is buying positive cash flow properties on the premise they can make money.”

He recently joined us for a video interview with Steve Johnson, CIO of global asset manager Forager Funds where they debated the merits of investing in residential real estate versus stocks. I have also summarised a few of the key answers which you can also read below.

The case for equities:

I started by asking Johnson and Bates why residential property doesn't fit the bill as a dependable source of income, and how it compares to stocks – both on the income front and as an investable asset more broadly?

As Bates explained, you can only deduct the mortgage interest you accrue on the property, then typically pay between 40% and 50% tax on the profit.

“You should only be buying a property for capital growth. And this is why, when you get to retirement, you don't want to buy a big lumpy property that's going to give you a yield of 4% or 5%,” Bates said.

“At this point, I'd much rather do what Steve's saying: Own shares.”

(And we’re talking exclusively about residential property – we all agree that commercial property is a different story).

“I think everyone agrees that you're going to get a higher yield out of shares now than from any sort of property portfolio. It's returning around 3.5% or 3.6% if you just buy the index,” said Steve Johnson, CIO at global asset manager Forager Funds.

Johnson added that fully franked, the grossed-up return will get you between 4.5% or 5% in taxable income every year. It's pretty hard to find any reasonable property that will give you that sort of return after you also consider all of your costs – particularly if you’re happy with less capital growth on the other side of the equation,” he said.

“The actual near-term income characteristics are probably in favour of shares.”

Never assume, because…

We’ve all heard the expression (Hint: there's a donkey - an ass, at least - in there). And assumption lies at the heart of a golden rule of investing: historical returns are no guarantee of future performance.

As Johnson explained, both asset classes (stocks and direct residential property) have returned about 8% a year when averaged over the last 50, 60 or 70 years. But as always, relying on historical returns is a fools’ game. And he believes it’s especially risky now.

“It's a dangerous time to be assuming that level of return will continue into perpetuity,” Johnson said. Pointing to the period when his grandparents bought their house in Sydney, in the 1950s, house prices were rising in line with incomes. In turn, the multiple you paid for a house was in line with that income.

“And the same was true of the stock market. It's bounced around all over the place, but that 15, 14 PE multiple for the ASX has been consistent over time. The returns have come from companies growing those earnings, and when it comes to housing, the returns have come from people's incomes going up and then being able to pay more and more for houses over time.”

Prepare to be disappointed

“That tailwind can't be behind both asset classes. People across the board should be expecting lower returns because of that,” Johnson said.

And then there’s also interest rates to factor in, with leverage working both ways.

“At today's interest rates, it's hard to imagine a world where you can't earn a higher return than the 1.8% or 9% you might be paying on a mortgage, but there will come a time where you're paying 4% and 5% on your mortgage. And then the leverage works in your favour, if you are making more than that, but it doesn't if things are less than that,” Johnson said.

Society is unequal

Bates agrees, but with some caveats.

“It's not a fair society that we have, right? Where everyone gets the same wage rise. A certain pocket has had great income rises, and the number of people earning over $180,000 a year is much higher today than it was five years ago,” he said

“When you're thinking about property, the big mistake people make is that just getting into the market is the thing to do. But the problem is, like shares and companies, every single property grows at a different rate.”

Bates notes that the talk of rates rising is “massively deflationary.” “If rates rise from say 2.5% to 3.5%, is that going to scare the hell out of consumers? Yes. And we're a consumer society, so raising rates is going to be hard. And that's why a lot of the countries around the world haven't been able to lift them,” he said.

“We could see rates low for a long time. Owning a long-term property still seems a good bet versus renting, because based on current yields, it's even.

“That's the sort of long and the short of interest rates. Can they go lower? Probably not, but can they stay low? Yes.”

He acknowledges rising rates will slow the market – something we already saw earlier in 2021. The appetite for big mortgages dropped as fixed interest rates began to jump.

“But we know the problems that the RBA has with raising rates. They want to get unemployment down, to get wage growth, and keep our exchange rate, so there are difficulties for the RBA just to lift rates."

The problem, for Bates, is the potential “opportunity cost” of staying out of the property market because of concerns they’re heading higher.

“You can sit on the fence and say, ‘It's next year or the year after,' but it might not be. That's been the problem with the bond market for the last 30 years: they're thinking rates are going to rise, but what's happened?

Rate moves knock stocks, too

And of course, it’s not just property as an investment whose demand shifts in line with rate movements.

“Nobody's paying $8 a share for Sydney Airport (ASX: SYD) in an interest rate environment that's meaningfully higher than today,” says Johnson.

As he sees it, many stocks are currently priced for interest rates to stay low forever, with PE multiples overall far higher than 10 years ago,

“That’s because everyone's looking at interest rates and saying, ‘Well, I used to want sixes in terms of that yield component from the stock market, now I'm happy with four, four and a half, simply because what I can get in the bank is so much lower.’

“Asset prices across the board are going down if interest rates go up, and that's just a simple fact of life.”

Just before the bell

So, what do you do? Perhaps the biggest takeaway is that owning stocks versus residential property as an investment shouldn’t be a binary choice. There’s a place for both in a well-balanced portfolio.

And while neither stocks nor property lands a knockout blow (that wasn’t the expectation, either) Bates took a crack at the points just before the referee’s whistle.

“If you buy a property and it rises in value – and you are earning a decent income – you can then pull out the deposit that you just paid for that property in an equity release loan. It’s very easy to do,” Bates said.
“You can then get your $150,000 back, negative gear that and buy your shares. By doing them both, you basically build an asset base that you can redraw and then buy into shares.

And in his own final counter, Johnson reiterated his earlier point about the historical nature of the argument for both assets – but particularly property.

“The capital growth of the past isn’t necessarily representative of what you’ll get in future. We're at a very, very interesting inflexion point, globally, around this re-rating of assets to higher and higher prices,” he said.

“Whether you're investing in the share market or you're in property, it's worth contemplating – and it may not be the likely scenario – where for 20 or 30 years we have very placid asset price growth, if not the opposite, across various asset classes.

For that reason, he’s (unsurprisingly, given his line of work) happy sticking with the share portfolio and its dividends as something of a protection against that.

“I'm not saying there will be a dramatic change next year; I've had this concern for a long time and it's been wrong. That's the caveat. But I do think it's worth contemplating.”

To watch the full interview, click here to find the video:

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